Out of Ammo? The Eroding Power of Central Banks

Since the financial crisis, central banks have slashed interest rates, purchased vast quantities of sovereign bonds and bailed out banks. Now, though, their influence appears to be on the wane with measures producing paltry results. Do they still have control?
The skyline of Frankfurt with the new ECB building in the background: "Exhausting the policy room for manoeuver."

The skyline of Frankfurt with the new ECB building in the background: "Exhausting the policy room for manoeuver."

Foto: Boris Roessler/ dpa

Once every six weeks, the most powerful players in the global economy meet on the 18th floor of an ugly office building near the train station in the Swiss city of Basel. The group includes United States Federal Reserve Chair Janet Yellen and her counterpart at the European Central Bank (ECB), Mario Draghi, along with 16 other top monetary policy officials from Beijing, Frankfurt, Paris and elsewhere.

The attendees spend almost two hours exchanging views in a debate chaired by Bank of Mexico Governor Agustín Carstens. Waiters serve an exquisite meal and expensive wine as the central bankers talk about the economy, growth and market prices. No one keeps minutes, but the world's most influential money managers are convinced that the meetings help expand their knowledge in important ways. "We learn what makes our counterparts tick," says one attendee.

These closed-door meetings, which are held on Sunday evenings, have a long tradition. But ever since many central banks lowered their interest rates to almost zero, bought up sovereign debt and rescued banks, a new, critical undertone has crept into the dinner conversations. Monetary experts from emerging economies complain that the measures taken by Europeans and Americans are pushing unwanted speculative money their way. Western central bankers say they have come under growing political pressure. And recently, when the host of the meetings -- head of the Basel-based Bank for International Settlements Jaime Caruana -- speaks in one of his rare public appearances, he talks about "chronic post-crisis weakness" and "risk." Monetary institutions, says Caruana, are at "serious risk of exhausting the policy room for manoeuver over time."

These are unusual words, especially now that the world's central bankers, five years after the Lehman crash, are more powerful than ever. They set interest rates and control the money supply, oversee governments and banks and, like Bank of England Governor Mark Carney, are treated a bit like movie stars by the public.

To an extent unprecedented in postwar history, monetary watchdogs -- who are not elected and are usually independent of their countries' governments -- determine what happens in politics and on the markets. They are the new "masters of the universe." Yet their internal discussions on the effects of their power do not give the impression of resounding success. Growth is limping along in the world's major economies; banks, households and governments are deeply in debt; and the bankers' so-called unconventional monetary policy is running up against its limits everywhere.

Holding onto the Wheel

In the United States, the members of the Federal Reserve Board of Governors are grappling with the question of when they should stop spending trillions to buy up treasury bonds. In the United Kingdom, the central bank is confusing the public with contradictory announcements about future interest-rate decisions. And in Europe, the divided monetary watchdogs on the ECB Council are searching for a way to combat low inflation rates.

At the most recent meeting of the International Monetary Fund (IMF) in Washington, financial policy experts and bank industry executives urged central banker governors to continue their policy of cheap money. More bond purchases were discussed, as were negative interest rates and central bank deals involving collateralized debt securities. It almost seems as though monetary policy officials are now being asked to come up with as many financial innovations as investment bankers once did.

The Swashbuckler

The central bank heads aren't particularly impressed. They are more inclined to believe they have done enough already and wonder whether their actions might now be doing more harm than good. Interviews with central bankers and monetary theorists leave the impression of a vast cognitive divide: Whereas the public wants central banks to continue driving the economy, bank heads feel they are increasingly no longer the only ones holding onto the wheel.

If there is a cowboy among global central bankers, it is Richard Fisher. The president of the Federal Reserve Bank of Dallas, Fisher wears his hair a few centimeters over his collar, his red cufflinks are decorated with gold dollar signs and when he talks about monetary policy, he occasionally quotes Country music icon Dolly Parton or digresses into observations as to how much beer his fellow Americans drink.

His hero is Paul Volcker, the crusty Fed chairman from the 1980s, who aggressively banished the specter of inflation from the United States. Against the will of then President Jimmy Carter and much of the public, he pushed the prime rate to record highs. This led to a severe recession, but it also put an end to double-digit inflation. For Fisher, Volcker remains "the Moses of monetary policy."

The only problem is that since the financial crisis, the scripts followed by central bankers no longer contain elements of Western movies, but instead resemble the American TV series "Emergency Room." No one is more aware of this than Fisher, who was present in the intensive care unit after the Lehman crash, when the government had to take over major US banks and protect the financial sector from collapse. Interest rates were reduced to almost zero and the government bought up treasury bonds on a large scale.

The rescue effort was ultimately successful, and yet the patient still hasn't yet fully recovered. The economy is only slowly gaining steam and many factories are not operating at full capacity. This has prompted some of Fisher's counterparts on the Fed Board of Governors to advocate pumping even more money into the economy. Fisher, on the other hand, finds it disconcerting that the Fed has already bought up sovereign bonds and mortgage-backed securities worth $18 trillion -- a sum comparable to a quarter of the entire US government debt -- with little effect.

Lonely Warriors

That's because much of the money flowing into the financial sector did not reach the private sector in the form of credit, as central bankers had expected. Instead, banks are pumping it into the stock market, where prices have reached dizzying highs in recent months. Values are now approaching levels similar to those before Black Friday in 1929 and the bursting of the dotcom bubble 70 years later.

Part of the blame lies with politicians in Washington, who are unable to agree on the federal budget. Companies don't invest as long as they don't know how their tax burden will look in the coming years, and as long as they don't invest, the economy will remain sluggish. The central bank's fuel isn't reaching the engine, Fisher warns, adding that it is bubbling in a giant gas tank that could explode at any moment.

If that happens, how can inflation be prevented, Fisher asks? How should the monetary watchdogs react if the markets collapse? And how will citizens respond to the losses that the central bank will inevitably incur if treasury securities lose value? Will they accept this without complaint, or will they bend to the will of politicians on the fringes of the left and right, who argued in the last presidential election that the Fed should be placed under government control?

In the past, central bankers felt like lonely warriors whose primary task was to hurl a powerful "no!" at politicians at just the right moment. Today the comparison they are more likely to use is to explorers like Vasco da Gama, who discovered the sea route around the Cape of Good Hope in the 15th century. We are sailing through unfamiliar waters, says Fisher, and we don't know if we will end up falling off the globe.

The Star

It takes Mark Carney fewer than eight minutes to explain how he and his counterparts intend to save the world. It is a Monday evening in late March and financial journalists are sitting in a windowless room at the Bank of England. The air is hot and stuffy, and yet when Carney hurries into the room, he looks like an actor who has just emerged from the makeup room, with his perfectly tailored suit and tie and his relaxed gait.

In addition to his job as governor of the UK's central bank, Carney heads the global Financial Stability Board (FSB), in which monetary watchdogs, regulators and experts from around the world attempt to repair the vast financial sector, with its banks, funds and rating agencies. The G20 nations created the FSB after the financial crisis to serve as a crisis research center for the financial world.

When Carney, in his loose and yet businesslike tone, rattles off the FSB's latest project -- to regulate the derivative markets and solve the problem of mega banks that are much too big -- he still sounds a little like the somewhat overbearing Goldman Sachs investment banker he was for 13 years. Perhaps it is also the devilish smile that makes him look a bit like George Clooney, or the fact that men's magazine GQ has touted him as a style icon, but it is clear that Carney is a new type of central banker -- not some dry head of a government bureaucracy, but a cosmopolitan money manager who also happens to have created a new business segment, the transfer market for central bank heads.

Carney served as governor of the Bank of Canada for many years. And because Canada survived the financial crisis largely unscathed, British Chancellor of the Exchequer George Osborne brought Carney to the Bank of England a year ago in the hopes that he would achieve similar miracles for the UK. His annual salary, housing allowance included, went up to the equivalent of €1 million -- seven times as much as US Fed Chair Yellen is paid. Osborne complied with Carney's request for a shortened term, the Bank of England's mandate was expanded and supervision of British banks was added to its duties.

Fading Aura

Since then, Carney has done his best to behave like the superstar he has been billed as. He brought management consultants into the cathedral-like premises of the Bank of England to improve work practices, he likes to be called "Mark," he eats in the cafeteria and he sometimes takes the subway.

But his new colleagues in Britain have remained unmoved by the big Carney show. Some veteran monetary policymakers stoically thwarted the Canadian's efforts to bring his innovations across the Atlantic. Carney wanted to put an end to the secrecy surrounding interest-rate decisions and instead issue a regular "forward guidance" -- a precise description of what the bank plans to do in the future.

In Canada, his approach kept the mood refreshingly calm during the crisis. But Carney's new colleagues are unwilling to be pinned down. In August, the central bank promised to keep prime lending rates low until the unemployment rate had dropped to 7 percent. But there were so many caveats that the markets hardly took the promise seriously.

In mid-February, the new Bank of England governor was forced to step back from his own announcement. Employment had improved so strongly that the 7 percent threshold had become far too immediate a possibility. Now Carney, trying to preserve his aura of coolness, declared that the unemployment rate was not an automatic "trigger" for an increase in interest rates. After all, such an increase would only stifle the eagerly anticipated upturn.

Since then, the newcomer's aura has faded considerably. As the British pound strengthens and real estate prices rise to worrying levels in several regions, Carney is coming under growing criticism. Many are beginning to notice that the Bank of England's balance sheet is still completely bloated, because England's monetary watchdogs bought large amounts of government debt during the crisis.

"I suspect," says Martin Weale, a member of England's Monetary Policy Committee, "people might be expecting a bit too much of (central banks)." In the end, he explains, a central bank has only one central instrument: the interest rates. "You can't deliver four or five different things with it."

The Doyen

Mario Draghi knows that a single sentence can sometimes work miracles, but that it can also produce catastrophes, especially in monetary policy. As he explains the ECB's latest decisions to journalists on this day in early April, he bends over his manuscript and simply rereads the key sentence in his initial speech -- like a teacher who isn't quite sure that everyone has been paying attention.

"The Governing Council is unanimous in its commitment to using" Draghi begins, looks pointedly at his audience, underscores his next word, "also," then pauses again and continues, "unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation."

This means that conventional measures have not been fully exploited yet, he adds.

Got it? Draghi has developed knack for impressing the markets with ambiguous sentences. His latest creation is a response to an unsettling number: 0.5 percent. That was the level of inflation in the euro zone in March. According to ECB standards, a 2 percent rate of inflation is considered healthy. Even the central bankers did not predict such a sharp decline.

What's more, the classical weapon generally deployed in such situations has been largely exhausted, now that the ECB's key interest rate is at a historically low 0.25 percent.

Little Impact?

One of the ironies of recent monetary history is that this dilemma is creating common ground between Draghi and his greatest opponent on the ECB Council. For years Jens Weidmann, head of Germany's central bank, the Bundesbank, irked Draghi with his repeated public warnings  against throwing vast sums of money at ailing euro zone countries.

But now? The two men appear to have reached consensus when it comes to euro-zone inflation. First they stressed that the current situation could only be characterized as low inflation, but not deflation. Then they announced, almost simultaneously, that they were willing to take action if inflation continued to weaken.

Draghi and Weidmann apparently hope that their words will be sufficient, eliminating the need for actual intervention. Both men know, after all, that measures, such as programs to buy up securities, are expensive but may have little impact. ECB experts have calculated that even if the central bank purchased securities for €1 trillion, this would only increase the inflation rate by between 0.2 and 0.8 percentage points.

This presents Weidmann and Draghi with a dilemma. Now that the classic ammunition is all but used up, they are trying to control the markets with words. Perhaps their words will have the desired effect. But it's also possible that the bluff will fall flat, forcing them to take measures they do not particularly support -- with risks and side effects that can only be surmised.

The Researcher

Why is it that so many central bankers are struggling with their decisions these days? Perhaps no one knows better than the short, gray-haired Italian who is storming out of his office with open arms. Claudio Borio is the chief economist of the Bank for International Settlements, the influential financial institution that serves as the bank for central banks and as their think tank.

The slightly built economist is little known outside the isolated world of monetary policy experts. But within their world, Borio is a respected man -- and has been since he was one of the few economists to have correctly predicted the financial crisis.

Borio has continued his research since then, analyzing countless data on interest rates, inflation trends and growth rates, and fine-tuning his theories. His central message is that the same forces that led to the financial crisis are still at work today. This is why the measures taken by central bankers are often ineffective and established economic models don't work, he says. "The disadvantage of mainstream macroeconomic models is that they ignore the financial cycle," he says.

Borio points to a chart on his glass-topped conference table. It depicts two curves that reflect half a century of US economic history.

Graphic: Business cycle versus financial market fluctuations.

Graphic: Business cycle versus financial market fluctuations.


The blue graph portrays economic trends, along with the known watersheds: the two oil crises in the 1970s and 80s, the dotcom crash around the turn of the millennium, and the sharp economic slump following the Lehman bankruptcy. The red curve isn't nearly as well known but is at least as important. It reflects fluctuations in the financial sector, for which Borio uses the growth in loans and real estate prices as an indicator. There are only minor fluctuations in the cycle until well into the 1980s, because the capital markets were still highly regulated and nationally isolated until then.

Inadvertent Influences

But then, as deregulation and globalization took hold, the financial sector becomes increasingly separated from the real economy, following the self-fueling logic of speculation, under which a bull market feeds a bull market and a bear market a bear market.

The fluctuations in this economic parallel universe reach massive dimensions in the 1990s. The only problem is that monetary watchdogs weren't watching. They remained exclusively oriented toward the ups and downs of the real economy, in keeping with the prevailing geopolitical doctrine: When prices rise during a recovery, central banks raise interest rates to avert inflation. When the economy declines, they reduce the cost of borrowing.

What they overlooked is that their decisions inadvertently influence the fluctuations in the financial markets. In 1987, for example, the Fed reduced interest rates following a market crash. Its aim was to avert a recession, but instead it stimulated an unhealthy boom in the housing market, which led to a sharp decline in prices soon afterwards and the collapse of hundreds of savings banks.

A decade later, it was the terrorist attacks of Sept. 11, 2001 that prompted the Fed to flood the markets with money. But that time the bubble didn't just build in the real estate market, but also in the lending and banking sector, ultimately leading to the crash of the century and the ensuing financial crisis. In attempting to control the economy, the central bankers created "a monster," as former German President Horst Köhler once put it. They have become hostage to the financial industry.

Borio has reached the end of his little story about money. He has a clear picture of the problem but no simple solutions.

Central banks were, of course, doing the right thing when they did everything in their power to avert a crash, but now they have exhausted their options. In the United States, the Fed bought up trillions in treasury bonds, but it cannot force politicians in Washington to reach an agreement in the budget fight. In Europe, the ECB flooded the banks with liquidity, but is unable to restructure the institutions. In the UK, the Bank of England has pledged to keep interest rates low for the foreseeable future, but it is unable to create jobs by itself. "Monetary policy is overburdened," says Borio.

'A Different Matter'

No matter what central bankers do, the pendulum swings of an unfettered credit sector either render their impulses ineffective or amplify them to such an extent that they become a threat. "Policy has to make sure that the financial cycle is not disruptive," says Borio.

For this reason, he explains, governments must exert tighter control over banks and financial institutions, but monetary policy experts also have a role to play. They shouldn't just focus on the economy, but also pay attention to the financial cycle. This means raising interest rates when a recovery threatens to become overheated, and otherwise to remind themselves of a virtue they once practiced more assiduously: doing nothing -- and urging those to take action who can truly bring about change, such as policymakers, bankers and business owners.

Central bankers are familiar with Borio's analysis, and many agree with him. But a larger number know that it isn't popular at the moment. "Central bankers have started to acknowledge that financial cycles are important," says the economist. "But how far they are prepared to take action is another question."

Translated from the German by Christopher Sultan
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